Quantity Theory of Money.
The most important feature of this theory is that it suggest that
interest rates have no effect on the demand for money.
of Money and the Equation of Exchange.
- Velocity of Money. The value of turnover of money, i.e., the average
number of times per year that a KD is spent in buying the total amount of goods
and services produced in the economy:
= P.Y / M.
both sides by M we obtain the equation of exchange, which relates nominal income
to the quantity of money and velocity.
. V = P . Y ( the equation of exchange )
the quantity of money multiplied by the number o times this money spent in a
given year must equal nominal income.
- The Quantity Theory of Money: According to the theory, velocity is
constant in the short run. Moreover, classical economists thought that wages and
prices were completely flexible and that the
aggregate level of output produced in the economy ( Y ) would remain at the full
employment level, i.e., constant in the short run.
The quantity theory of money then implies that if M doubles, since V and
Y are constant, P also must double e.g.,
P.Y = 5 billion, while M = 1 billion, then
= 5/1= 5.
Money supply doubles to 2 billion, the price level must also double and
= 2 ´
= 10 billion
for classical economists, the quantity theory of money provided an explanation
of movements in the price level: Movements in the price level result solely from
changes in the quantity of money.
The Quantity Theory of Money Demand.
at the equation of exchange;
. V = P . Q.
If we divide both sides by V we get
= 1 / V . P . Q or,
k is constant, since V is constant.
Hence the level of
transactions determines the quantity of money that people demand.
Therefore, Fisher’s theory of money suggests that the demand for money
is purely a function of income and interest rates have no effect on the demand
for money. The demand for money is determined by:
the level of nominal income ( P.Y )
institutions in the economy that affect the way people conduct transactions
which determine velocity and hence, k.
The Cambridge Approach to Money Demand.
The Cambridge economists asked how much money individuals would want to
hold. They recognized that money has two properties that motivate people to hold
Money functions as a medium of
exchange that people can use o carry out transactions, i.e., the demand for
money would be related to the level of transactions.
Money functions as a store of
wealth: the level of people’s wealth also affects the demand for money. As
individuals wealth grows, they need to store it. Money is one of the assets.
They concluded that the demand for money would be proportional to nominal
income and expressed the demand for money function as;
This equation looks like Fisher’s money demand equation. However, it
does not mean that the Cambridge group agreed with Fisher that interest rates
play no role in the demand for money.
The Cambridge group approach allows individuals to choose how much money
they want to hold. Hence Cambridge approach emphasized individuals choice and
did not rule out effects of interest rates.
Liquidity Preference Theory.
Keynes abandoned the classical view that velocity is constant an
developed a theory of money that emphasized the importance of interest rates. He
called it Liquidity Preference Theory.
Keynes postulated that there are three motives behind the demand for money:
- The Transactions Motive: Individuals are assumed to hold money because
it is a medium of exchange that can be used carry out every day transactions.
This demand is primarily determined by the level of people’s transactions.
Since transactions are proportional to income, the transactions demand for money
is also proportional to income.
- The Precautionary Motive: people hold additional money as a cushion
against an unexpected need, e.g., a major car repair, hospitalization, … etc..
This demand for money is also determined by the level of transactions they
expect to make in the future which are proportional to income. Hence this demand
is proportional to income.
- The Speculative Motive: Keynes agreed with the classical Cambridge
economists that money is a store of wealth and called this motive for holding
money the speculative motive. Keynes divided assets that can be used to store
wealth into two categories: Money and Bonds. He then asked, why would
individuals decide to hold their assets in the form of money rather than bonds?
People would hold money if its expected return is higher than the
expected return on bonds.
Keynes assumed that that the expected return on money is zero, while the
expected retrun on bonds are:
the interest payment
the expected rate of capital gain.
There is a negative relationship between interest rates and the price of
bonds. If interest rates are expected to increase people will prefer to hold
money rather than bonds and vice versa.
Keynes assumed that there is a normal level of interest rate, below it
people will prefer to hold money rather than bonds to avoid any capital loss in
the future when interest rates increased.
If interest is below that normal level, people will prefer to hold their
wealth in money, not bonds to avoid any capital loss if interest rate declined
in the future, and vice versa.
RESULT; money demand in negatively related
to interest rate levels.
Putting the Three Motives Together.
distinguished between nominal quantities and real quantities of money. People
want to hold a certain amount of real money balances which is related to real
income ( Y ) and interest rates ( i ) :
The liquidity preference function means that the demand for real money
balances is negatively related to interest rates ( i ) and positively related to
The liquidity preference can be written as
P / M = 1/ f( i, Y ).
both sides by Y
P.Y / M = Y / f( i, Y ).
( i ) increases, f ( i, Y ) declines ( money demand ) and therefore velocity
rises. Velocity also will change with expectations about future normal levels of
interest rates. Hence, Keynes rejected the view that velocity could be treated
Further Developments in the Keynesian
- The Transactions Demand.
Baumol and Tobin developed similar demand for money models which
demonstrated that even money balances held for transactions purposes are
sensitive to the level of interest rates.
Suppose that Ali receives KD
1000 at the begining of the month and spend it on transactions, i.e., by the
begining of each month he will have KD 1000 and by the end of the month he will
have zero. His holdings of money will be KD 500 ( 1000+0/2). He will have KD
12000 per year and since his holdings of money are 500 on average, then the
velocity of money V=P.Q/M = 12000/500=24. ( see firgure ( 1 ) below. Suppose
that Ali realises that he can hold part of the money balances in cash and the
rest in interest bearing assets ( bonds ). So at the begining of the month he
will receive 1000, he will hold 500 cash and buy a bond by the other 500. He
will start spending under the middle of the month when cash balances drop to
zero. He then sell his bonds and get cash of 500 to spend them in the next 15
days until his balances drop to zero. This process contiues each month. The net
result is that his average balances 500/2=250. Velocity is then doubled to
Suppose that the interest rate is 1% per month, then his interest would
x 1/2 x 1% = KD 2.5.
Of course he would be better if he holds KD 333.33 and buys KD 666.667
bonds. and his average cash balances would be 333.333/2=167.67, and more better
if he holds KD 250 cash and 750 bonds. etc.. The less cash he is holding the
more bonds he buys he will earn more interest. But remember that in order to buy
and sell bonds Ali will have to pay brokerage fees, and make more trips to the
bank or the stock market. Hence fees
time cost is his
Ali must strike a balance between the return that he will have and the costs
that he will pay ( including the time ). If the rate of interest is high, the
benefits of bonds will be high, and vice versa.
The conclusion of Baumol-Tobin is that:
the interest rates increase, the amount of cash held for transactions purposes
will decline, which in turn means that the velocity increases as interest rate
increase. In another way:
THE TRANSACTIONS COMPONENTS OF THE DEMAND FOR MONEY IS NEGATIVELY RELATED
TO THE LEVEL OF INTEREST RATES.
The basic idea is that there is an opportunity cost of holding money (
the interest that can be earned on other assets) and there is benefits of money;
the avoidance of transactions costs. When interest rate incereases we will try
to economize on our holdings of money for transactions costs since the
opportunity costs will be high. Hence the transactions demand for money is
sensitive to interest rates.
Similar to the transactions demand, as interest rates increase rise, the
opportunity costs of holding precuationary balances rises, and so the holdings
of these money money balances fall. Hence:
THE PRECAUTIONARY DEMAND FOR MONEY IS NEGATIVELY RELATED TO INTEREST
Friedman’s Modern Quantity Theory of
Instead of analyzing the specific motives for holding money, friedman
simply stated that the demand for money must be influenced by the same factors
that influence the demand for any other asset. He applied the theory of asset
demand to money. The demand for real money balances is as follows:
= Permanent income
= the expected return on money
= the expected return on bonds
= the expected return on equities
= the expected inflation rate
Between Friedman and Keynes’ Theories.
There are several differences between Friedman’s and the
Friedman recognized that more than
one interest rate is important to the operation of aggregate economy. Keynes
lumped financial assets other than money in one big category “ Bonds “.
viewed money and goods are substitutes, that is people choose between them when
deciding how much money to hold.
Friedman did not take the expected
return on money to be constant as did Keynes.
Unlike Keynes’s theory, which
indicates that interest rates are important determinant of the demand for money,
Friedman’s theory suggests that changes in interest rates should have little
effect on the demand for money. According to Friedman, the demand for money is
insensitive to interest rates. Also
Friedman’s money demand function is essentially depend on the permanent income.
Friedman stressed the stability the
stability of the demand for money function.
Friedman’s theory is simply a restatement of the quantity theory of
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